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Rising rate of interest

The US Federal Reserve cautiously signals that stable growth may lie ahead

May 19, 2017

In March 2017, for the third time in the past decade, the US Federal Reserve raised the federal funds target rate by a quarter percentage point to a range between 0.75 percent and 1 percent. While the increase represents only a minor adjustment to historically low rates, the willingness of the Fed to transition towards higher rates has far-reaching implications for investment portfolios. The task for asset managers now is to predict the speed of this upward trajectory in the months and years ahead and plan accordingly.

The good news is that the rate hike was in line with forecasts made by the Fed in December, 2016.1 Prior to the announcement, some analysts predicted there could be as many as three or four rate increases during 2017.2 However, Federal Reserve Chair Janet Yellen reassured investors that the Federal Open Market Committee (FOMC) intends to remain with its projection of just two quarter-point rate increases this year, with a further three scheduled in 2018.3

Regardless of whether interest rate increases are expected, investors will still need to carefully consider how increases might affect their portfolios

Inevitably, rate changes trigger market speculation. When assessing the impact of federal funds rate increases, the broader context behind the Fed's decision offers important insight. The FOMC has kept target rates at near zero for a longer period than at any other time in its history.4 Should the planned schedule for future rate hikes be implemented, it will be the most gradual and likely the most telegraphed rate hike in the history of the Federal Reserve.5 Regardless of whether interest rate increases are expected, investors will still need to carefully consider how increases might affect their portfolios.

Market and Investor Reactions

Rising interest rates are typically associated with volatile stock and bond markets. During periods of increasing interest rates, investors have traditionally reverted to cash savings as a means of absorbing shocks, but this is unlikely to be a profitable investment strategy when inflation outpaces interest rates. Investors may be tempted by a more cautious approach, but with the long-term incremental rate increases anticipated by the Fed, the pursuit of commodities and alternative investments may be more attractive than pulling out altogether.

When markets are bearish, and rates are failing to keep up with inflation, conventional wisdom is to invest in safe haven commodities. After a strong start to the year, March saw gold in decline until the announcement of the federal funds rate adjustment. In the aftermath, gold staged an impressive rally with an increase of 2.3 percent.6

Investors should consider assessing their appetite for risk in this environment

While the general outlook for US economic activity is upbeat, the rate hike has naturally impacted bond yields. For example, five-year Treasuries are now negative when adjusted for the price outlook.7 Investors should consider assessing their appetite for risk in this environment and ensure that their portfolios are adequately diversified, with stocks being an alternative to holding bonds.

Adopting a more active investment strategy means keeping a firm eye on government policy

Adopting a more active investment strategy means keeping a firm eye on government policy. President Trump has pledged a fiscal boost, but the exact shape of this policy has yet to be determined. Not only are tax cuts and infrastructure investments expected, but President Trump has also indicated plans for major financial deregulation, specifically his eagerness to repeal the Dodd-Frank Act. If this occurs, there will be major implications for asset managers, hedge funds, and private equity firms. Adding to the uncertainty over fiscal policy is the growing speculation that the President lacks the political support necessary to push through these changes.8 Investors need to pay close attention to these developments in the US markets, as well as closely following progressions abroad.

When the Fed adjusts interest rates, the rest of the world takes notice. Just hours after the federal funds target rate hike was announced, the People's Bank of China raised borrowing costs. This move has been seen as an attempt to protect the yuan by limiting the interest rate differential and safeguarding against systemic risk by reigning in excessive lending. Higher interest rates in the US draw capital and investments out of China, and investors should expect Asian equities futures to continue to trend downwards.

In a macro-economic environment where interest rates have hit record lows and even dipped into the negative in some markets, the FOMC's decision to raise the federal funds target rate is a bold step. The Federal Reserve may now be indicating to other central banks that it is moving beyond the spectre of the global financial crisis and anticipating a return to stable growth. For investors, the challenge is to move away from reliance on stable bond yields in favour of riskier, more diversified and less passive strategies.